Oil Down, DXY Up. But Does That Equal Less Inflation?
There's a relationship developing between crude oil, the US dollar, and inflation that I think deserves a closer look.
Oil prices have pulled back from their recent highs, while the US Dollar Index (DXY) has strengthened as investors do a double take on the path of interest rates.
Ol' Wall Street wisdom would suggest that both developments should help bring inflation lower...and to some extent, that's true.
Lower oil prices can reduce energy and transportation costs, while a stronger dollar can make imported goods less expensive.
But it feels like something is being overlooked...
Falling commodity prices and a stronger currency do NOT necessarily mean the underlying inflation problem has been resolved.
Oil. You're up first.
When crude prices decline, the immediate impact is generally felt at the gasoline pump often within days or weeks. But because energy is such a big economy input, influencing everything from agricultural production to manufacturing and transportation, those secondary effects take time to work through supply chains, contracts, and ultimately consumer prices (rip my Whole Foods bill).
So while oil has recently moved lower, some of the higher energy costs experienced over the preceding months may still be working their way into the prices consumers pay today.
That brings us to the dollar.
A stronger DXY does NOT necessarily mean your dollar is gaining purchasing power.
DXY measures the dollar's value relative to a basket of foreign currencies, heavily weighted toward the euro.
It doesn't measure how much food, housing, insurance, or energy your dollar can actually purchase.
In fact, the dollar can strengthen against other currencies while simultaneously losing purchasing power here at home.
Both can be true...and that's kind of whats been happening for awhile now. Checkout the DXY (purple) vs. the BLS Purchase Power Index (blue) above.
And while dollar strength can help moderate certain import prices, the effect is neither immediate nor uniform across the economy.
But here's where I think the discussion gets JUICYYY.
We need to distinguish between changes in relative prices and changes in the purchasing power of money itself.
If oil becomes more expensive because geopolitical tensions restrict supply, that reflects a change in the availability of that tasty liquid gold, I mean real resource.
The economy hasn't necessarily gained more money. It's simply facing a higher cost for an important input.
At the end of the day we as consumers and businesses must adjust, often by spending less elsewhere or accepting lower margins.
That's different from an environment in which monetary and credit expansion contribute to a broader decline in money's purchasing power.
Both can show up in CPI, but they aren't the same economic event.
And the distinction matters.
Consider two scenarios:
Oil declines because production increases, supply constraints ease, we stop destroying the vehicles that get the oil to us, etc. That's generally a positive development for the economy, freeing up resources and reducing costs.
Oil declines because economic activity is slowing and businesses are demanding less energy - or at least redirecting where that energy is coming from.
Same direction for oil prices. Very different implications for growth and corporate profits.
This is why I wouldn't automatically interpret falling oil and a rising dollar as evidence that the inflation problem is behind us.
The latest CPI report showed consumer prices rising 0.4% in October, but that report measures price changes that have already occurred.
Meanwhile, financial markets are continuously adjusting to expectations about future economic conditions. Which of course, neither gives us a complete picture on its own.
What I'm watching is whether lower oil prices are accompanied by improving supply conditions or deteriorating demand, whether dollar strength persists, and whether monetary and credit conditions are becoming more restrictive (which Chris has written about previously).
Because ultimately, the important question isn't simply whether oil is falling or DXY is rising, but whether we're seeing genuine improvements in the economy's productive capacity, or merely changes in market prices that temporarily make inflation look better.
Those are two very different stories.
